The value of the dollar is
falling. Does that mean that our economic sky is falling as well? Not to sound
like Chicken Little, but the answer may well be yes. If an economic collapse is
not in our future, then at least economic storm clouds are gathering on the
horizon.

It's what lies behind
the slide of the dollar that has even many mainstream economists spooked: an
unprecedented current account deficit--the difference between the
country's income and its consumption and investment spending. The current
account deficit, which primarily reflects the huge gap between the amount the
United States imports and the amount it exports, is the best indicator of where
the country stands in its financial relationship with the rest of the
world.

At an estimated $670
billion, or 5.7% of gross domestic product (GDP), the 2004 current account
deficit is the largest ever. An already huge trade deficit (the amount exports
fall short of imports) made worse by high oil prices, along with rock bottom
private savings and a gaping federal budget deficit, have helped push the U.S.
current account deficit into uncharted territory. The last time it was above 4%
of GDP was in 1816, and no other country has ever run a current account deficit
that equals nearly 1% of the world's GDP. If current trends continue, the
gap could reach 7.8% of U.S. GDP by 2008, according to Nouriel Roubini of New
York University and Brad Setser of University College, Oxford, two well-known
finance economists.

Most of the current account
deficit stems from the U.S. trade deficit (about $610 billion). The rest
reflects the remittances immigrants send home to their families plus U.S.
foreign aid (together another $80 billion) less net investment income (a
positive $20 billion because the United States still earns more from
investments abroad than it pays out in interest on its borrowing from abroad).

The current account deficit
represents the amount of money the United States must attract from abroad each
year. Money comes from overseas in two ways: foreign investors can buy stock in
U.S. corporations, or they can lend money to corporations or to the government
by buying bonds. Currently, almost all of the money must come from loans
because European and Japanese investors are no longer buying U.S. stocks. U.S.
equity returns have been trivial since 2000 in dollar terms and actually
negative in euro terms since the dollar has lost ground against the euro.

In essence, the U.S.
economy racks up record current account deficits by spending more than its
national income to feed its appetite for imports that are now half again
exports. That increases the supply of dollars in foreign hands.

At the same time, the
demand for dollars has diminished. Foreign investors are less interested in
purchasing dollar-dominated assets as they hold more of them (and as the
self-fulfilling expectation that the value of the dollar is likely to fall sets
in). In October 2004 (the most recent data available), net foreign purchases of
U.S. securities--stocks and bonds--dipped to their lowest level in a
year and below what was necessary to offset the current account deficit. In
addition, global investors' stock and bond portfolios are now overloaded
with dollar-denominated assets, up to 50% from 30% in the early 90s.

Under the weight of the
massive current account deficit, the dollar has already begun to give way.
Since January 2002, the value of the dollar has fallen more than 20%, with much
of that dropoff happening since August 2004. The greenback now stands at
multiyear lows against the euro, the yen, and an index of major
currencies.

Should foreign investors
stop buying U.S. securities, then the dollar will crash, stock values plummet,
and an economic downturn surely follow. But even if foreigners continue to
purchase U.S. bonds--and they already hold 47% of U.S Treasury bonds--a
current account deficit of this magnitude will be a costly drag on the economy.
The Fed will have to boost interest rates, which determine the rate of return
on U.S. bonds, to compensate for their lost value as the dollar slips in value
and to keep foreigners coming back for more. In addition, a falling dollar
makes imports cost more, pushing up U.S inflation rates. The Fed will either
tolerate the uptick in inflation or attempt to counteract it by raising
interest rates yet higher. Even in this more orderly scenario of decline, the
current expansion will slow or perhaps come to a halt.

Imperial Finance

You can still find those
who claim none of this is a problem. Recently, for example, the editors of the
Wall Street Journal offered worried readers the following relaxation
technique--a version of what former Treasury Secretary Larry Summers says
is the sharpest argument you typically hear from a finance minister whose
country is saddled with a large current account deficit.

First, recall that a large
trade deficit requires a large surplus of capital flowing into your country to
cover it. Then ask yourself, would you rather live in a country that continues
to attract investment, or one that capital is trying to get out of? Finally,
remind yourself that the monetary authorities control the value of currencies
and are fully capable of halting the decline.

If the United States Were an
Emerging Market

If the United States were a
small or less-developed country, financial alarm bells would already be
ringing. The U.S. current account deficit is well above the 5%-of-GDP standard
the IMF and others use to pronounce economies in the developing world
vulnerable to financial crisis.

Just how crisis-prone
depends on how the current account deficit affects the economy's spending.
If the foreign funds flowing into the country are being invested in
export-producing sectors of the economy, or the tradable goods sectors, such as
manufacturing and some services, they are likely over time to generate revenues
necessary to pay back the rest of the world. In that case, the shortfall is
less of a problem. If those monies go to consumption or speculative investment
in non-tradable (i.e., non-export producing) sectors such as a real estate,
then they surely will be a problem.

By that standard, the U.S.
current account deficit is highly problematic. Economists assess the impact of
a current account deficit by comparing it to the difference between net
national investment and net national savings. (Net here means less the money
set aside to cover depreciation.) In the U.S. case, that difference has widened
because saving has plummeted, not because investment has picked up. Last year,
the United States registered its lowest net national savings rate ever, 1.5%,
due to the return of large federal budget deficits and anemic personal savings.
In addition, U.S. investment has shifted substantially away from tradable goods
as manufacturing has come under heavy foreign competition toward the non-traded
goods sector, such as residential real estate whose prices have soared in and
around most major American cities.

Capital inflows that cover
a decline in savings instead of a surge in investment are not a sign of
economic health nor cause to stop worrying about the current account deficit.

Feel better? You
shouldn't. Arguments like these are unconvincing, a bravado borne not of
postmodern cool so much as the old-fashioned, unilateral financial imperialism
that underlies the muscular U.S. foreign policy we see today.

True, so far foreigners
have been happy to purchase the gobs of debt issued by the U.S. Treasury and
corporate America to cover the current account deficit. And that has kept U.S.
interest rates low. If not for the flood of foreign money, Morgan Stanley
economist Stephen Roach figures, U.S. long-term interest rates would be between
one and 1.5 percentage points higher today.

The ability to borrow
without pushing up interest rates has paid off handsomely for the Bush
administration. Now when the government spends more than it takes in to
prosecute the war in Iraq and bestow tax cuts on the rich, savers from foreign
shores finance those deficits at reduced rates. And cash-strapped U.S.
consumers are more ready to swallow an upside-down economic recovery that has
pushed up profit but neither created jobs nor lifted wages when they can borrow
at low interest rates.

How can the United States
get away with running up debt at low rates? Are other countries' central
banks and private savers really the co-dependent "global enablers" Roach and
others call them, who happily hold loads of low-yielding U.S. assets? The truth
is, the United States has taken advantage of the status of the dollar as the
currency of the global economy to make others adjust to its spending patterns.
Foreign central banks hold their reserves in dollars, and countries are billed
in dollars for their oil imports, which requires them to buy dollars. That
sustains the demand for the dollar and protects its value even as the current
account imbalance widens.

The U.S. strong dollar
policy in the face of its yawning current account deficit imposes a "shadow
tax" on the rest of the world, at least in part to pay for its cost of empire.
"But payment," as Robert Skidelsky, the British biographer of Keynes, reminds
us, "is voluntary and depends at minimum on acquiescence in U.S. foreign
policy." The geopolitical reason for the rest of the capitalist world to accept
the "seignorage of the dollar"--in other words, the advantage the United
States enjoys by virtue of minting the reserve currency of the international
economy--became less compelling when the United States substituted a "puny
war on terrorism" for the Cold War, Skidelsky adds.

The tax does not fall only
on other industrialized countries. The U.S. economy has not just become a giant
vacuum cleaner that sucks up "all the world's spare investible cash," in
the words of University of California, Berkeley economist Brad DeLong, but
about one-third of that money comes from the developing world. To put this
contribution in perspective: DeLong calculates that $90 billion a year, or
one-third of the average U.S. current account deficit over the last two
decades, is equal to the income of the poorest 500 million people in
India.

The rest of the world ought
not to complain about these global imbalances, insist the strong dollar types.
That the United States racks up debt while other countries rack up savings is
not profligacy but a virtue. The United States, they argue, is the global
economy's "consumer of last resort." Others, especially in Europe,
according to U.S. policymakers, are guilty of "insufficient consumption": they
hold back their economies and dampen the demand for U.S. exports, exacerbating
the U.S. current account deficit. Last year U.S. consumers increased their
spending three times as quickly as European consumers (excluding Britain), and
the U.S. economy grew about two and half times as quickly.

Global Uprising

Not surprisingly, old
Europe and newly industrializing Asia don't see it that way. They have
grown weary from all their heavy lifting of U.S. securities. And while they
have yet to throw them overboard, a revolt is brewing.

Those cranky French are
especially indignant about the unfairness of it all. The editors of Le
Monde, the French daily, complain that "The United States considers itself
innocent: it refuses to admit that it lives beyond its means through weak
savings and excessive consumption." On top of that, the drop of the dollar has
led to a brutal rise in the value of the euro that is wiping out the demand for
euro-zone exports and slowing their already sluggish economic
recoveries.

Even in Blair's
Britain the Economist, the newsweekly, ran an unusually tough-minded
editorial warning: "The dollar's role as the leading international
currency can no longer be taken for granted. Imagine if you could write
checks that were accepted as payment but never cashed. That is what [the
privileged position of the dollar] amounts to. If you had been granted that
ability, you might take care to hang to it. America is taking no such care. And
may come to regret it."

But the real threat comes
from Asia, especially Japan and China, the two largest holders of U.S. Treasury
bonds. Asian central banks already hold most of their reserves in
dollar-denominated assets, an enormous financial risk given that the value of
the dollar will likely continue to fall at current low interest rates.

In late November, just the
rumor that China's Central Bank threatened to reduce its purchases of U.S.
Treasury bonds was enough to send the dollar tumbling.

No less than Alan
Greenspan, chair of the Fed, seems to have come down with a case of dollar
anxiety. In his November remarks to the European Banking Community,
Green­span warned of a "diminished appetite for adding to dollar balances"
even if the current account deficit stops increasing. Greenspan believes that
foreign investors are likely to realize they have put too many of their eggs in
the dollar basket and will either unload their dollar-denominated investments
or demand higher interest rates. After Greenspan spoke, the dollar fell to its
lowest level against the Japanese yen in more than four years.

A Rough Ride From Here

The question that divides
economists at this point is not whether the dollar will decline more, but
whether the descent will be slow and orderly or quick and panicky. Either way,
there is real reason to believe it will be a rough ride.

First, a controlled
devaluation of the dollar won't be easy to accomplish. Several major Asian
currencies are formally or informally pegged to the dollar, including the
Chinese yuan. The United States faces a $160 billion trade deficit with China
alone. U.S. financial authorities have exerted tremendous pressure on the
Chinese to raise the value of their currency, in the hope of slowing the tide
of Chinese imports into the United States and making U.S. exports more
competitive. But the Chinese have yet to budge.

Beyond that, a fall in the
dollar sufficient to close the current account deficit will slaughter large
amounts of capital. The Economist warns that "[i]f the dollar falls by
another 30%, as some predict, it would amount to the biggest default in
history: not a conventional default on debt service, but default by stealth,
wiping trillions off the value of foreigners' dollar assets."

Even a gradual decline in
the value of dollar will bring tough economic consequences. Inflation will pick
up, as imports cost more in this bid to make U.S. exports cheaper. The Fed will
surely raise interest rates to counteract that inflationary pressure, slowing
consumer borrowing and investment. Also, closing the current account deficit
would require smaller government deficits. (Although not politically likely,
repealing Bush's pro-rich tax cuts would help.)

What will happen is
anyone's guess given the unprecedented size of the U.S. current account
deficit. But there is a real possibility that the dollar's slide will be
anything but slow or orderly. Should Asian central banks stop intervening on
the scale needed to finance the U.S. deficit, then a crisis surely would
follow. The dollar would drop through the floor; U.S. interest rates would
skyrocket (on everything from Treasury bonds to mortgages to credit cards); the
stock market and home values would collapse; consumer and investment spending
would plunge; and a sharp recession would take hold here and abroad.

The Bush administration
seems determined to make things worse. Should the Bush crew push through their
plan to privatize Social Security and pay the trillion-dollar transition cost
with massive borrowing, the consequences could be disastrous. The example of
Argentina is instructive. Privatizing the country's retirement program, as
economist Paul Krugman has pointed out, was a major source of the debt that
brought on Argentina's crisis in 2001. Dismantling the U.S. welfare
state's most successful program just might push the dollar-based financial
system over the edge.

The U.S. economy is in a
precarious situation held together so far by imperial privilege. Its prospects
appear to fall into one of three categories: a dollar crisis; a long, slow,
excruciating decline in value of the dollar; or a dollar propped up through
repeated interest rates hikes. That's real reason to worry.

John Miller teaches
economics at Wheaton College and is a member of the Dollars & Sense
collective.

RESOURCES
"Dollar Anxiety," editorial, Wall Street Journal, 11/11/04; D. Wessel,
"Behind Big Drop in Currency: U.S. Soaks Up Asia's Output," WSJ,
12/2/04; J. B. DeLong, "Should We Still Support Untrammeled International
Capital Mobility? Or are Capital Controls Less Evil than We Once Believed,"
Economists' Voice, 2004; R. Skidelsky, "U.S. Current Account
Deficit and Future of the World Monetary System" and N. Roubini and B. Setser
"The U.S. as A Net Debtor: The Sustainability of the U.S. External Imbalances,"
11/04, Nouriel Roubini's Global Macroeconomic and Financial Policy site
<www.stern.nyu.edu/globalmacro>; Rich Miller, "Why the Dollar is Giving
Way," Business Week, 12/6/04; Robert Barro, "Mysteries of the Gaping
Current-Account Gap," Business Week, 12/13/04; D. Streitford and J.
Fleishman, "Greenspan Issues Warning on Dollar," L.A. Times, 11/20/04;
S. Roach, "Global: What Happens If the Dollar Does Not Fall?" Global Economic
Forum, Morgan Stanley, 11/22/04; L. Summers, "The U.S. Current Account Deficit
and the Global Economy," The 2004 Per Jacobsson Lecture, 10/3/04; "The Dollar,"
editorial, The Economist, 12/3/04; "Mr. Gaymard and the Dollar,"
editorial, Le Monde, 11/30/04.